Today

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Todays Agenda

• Note on TF office hours W, 130-230pm, KMEC
  7-181,TF Ms. Desi Peteva, MBA2
• Why study intl monetary systems?
• Terminology of exchange rates currency regimes.
• Differences b/n devaluation depreciation?
• Ideal currency?
• Explain currency regime choices.
• Describe Euro creation.
• Case-in-point the stubborn forex regime in China.

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Why study intl monetary system?

• Fact the volatility of exchange rates has
  increased.
• Volatile exchange rates increase risk, create
  profit opportunities.
• The international monetary system is the
  structure within which foreign exchange rates are
  determined.

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Currency Terminology

• Foreign currency exchange rate price of one
  countrys currency in units of another currency
  or commodity
• The system, or regime, classified as
• fixed,
• floating, or
• managed exchange rate regime.
• Par value the rate _at_ which currency is fixed,
  pegged.
• Floating or flexible currency government does
  not interfere in valuation of currency

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Currency Terminology

• Spot exchange rate quoted price for foreign
  exchange to deliver _at_ once, or _at_ T2 for
  interbank transactions
• 114/ (114 yen to buy one US ), immediate
  delivery
• Devaluation drop in foreign exchange value
  pegged to gold or another currency. Opposite to
  revaluation.
• Weakening, depreciation refers to drop in
  foreign exchange of a floating currency. Opposite
  to appreciation.

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Currency Terminology

• Soft or weak currency currency expected to
  devalue/ depreciate relative to major currencies
  
• Hard or strong the opposite.
• Eurocurrencies type of money although in reality
  they are domestic currencies of a country
  deposited in another country.
• E.g. Eurodollar - US denominated deposit in
  bank outside of US

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Evolution of the International Monetary System

• Bimetallism Before 1875
• Classical Gold Standard 1875-1914
• Interwar Period 1915-1944
• Bretton Woods System 1945-1972
• The Flexible Exchange Rate Regime 1973-Present

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Bimetallism Before 1875

• A double standard both gold and silver were
  used as money, accepted as means of payment.
• Some countries were on the gold standard, some on
  the silver standard, some on both.
• Exchange rates among currencies were determined
  by either their gold or silver contents.

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The Gold Standard, 1876-1913

• Countries set par value for currency in terms of
  gold
• Acceptance in Europe in 1870s
• US adopted it 1879
• Rules of the game
• Rule 1 Set a rate _at_ which can buy/sell gold for
  currency.
• Rule 2 Credibly maintain adequate reserves of
  gold.
• E.g. US gold rate 20.67/oz, Brits pegged at
  4.2474/oz
• US/ rate calculation
• 20.67/4.2472 4.8665/

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The Gold Standard, 1876-1913

• Since the rate of exchange for gold was fixed,
  the exchange rates b/n currencies was fixed too.
• Gold standard worked until WW1
• WW1 interrupted trade flows free movement of
  gold forcing nations suspend gold standard.
• J.M. Keynes called it the barberian relique.

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Inter-War years WWII, 1914-1944

• During WWI currencies fluctuate over wide ranges
  to gold
• Due to S D for imports/exports
• Due to speculative pressure,
• SHORT SELLING week currencies.
• BUYING strong currencies.
• SHORT SELLING investor expects price to fall
  soon, borrows currency sells it.
• 1934 US devalued currency to 35/oz from
  20.67/oz.
• 1924 - end WWII exchange rates determined by
  currency value in gold.
• During WWII after, main currencies lost
  convertibility. US remained only convertible
  currency.

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Bretton Woods IMF

• Bretton Woods, NH US coalition created post-war
  international monetary system.
• establishes US based monetary system
• IMF (International Monetary Fund) World Bank
• IMF renders temp assistance to member-countries
  to defend currency overcome econ problems
• All member-countries fix currencies in gold, not
  required to exchange it.
• Only US convertible to gold (_at_ 35/oz, Central
  banks only)
• The advent of central banking worldwide.

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Bretton Woods

• Countries establish exchange rate vis-à-vis US
• Agree to maintain currency values /- 1 par by
  trading US gold.
• No use of devaluation as a competitive trade
  policy
• Up to 10 devaluation w/o formal approval by IMF.

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Bretton Woods

• Special Drawing Right (SDR) international
  reserve assets
• A unit of account for IMF base some countries
  peg exchange rates.
• Is weighted average 5 IMF members currencies, w/
  largest exports/ imports
• Members deposits US Gold in IMF, get SDR.

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Fixed exchange rates, 1945-1973

• Worked well for post-WW2
• Fiscal monetary policies external shocks
  caused collapse
• US main reserve currency.
• Heavy overhang of US abroad.
• Lack of confidence.
• Heavy outflows of US gold.
• Nixon (08/15/71) suspend trading gold. Allow
  exchange rates to float freely.
• Nixon (08/15/71) yet another run on US.
• Devalue US to 42/oz gold.

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Fixed exchange rates, 1945-1973

• Triffin paradox
• To maintain the gold-exchange system, the US had
  to run Balance of Payment deficits continuously.
• But large, persistent deficits would diminish
  confidence and lead to a run on the US.
• This would destroy the system indeed, it
  happened in the 50s 60s.

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World Currency Events
OPEC embargo 1973-74 Jamaica Agreement 1/1976 EMS created 3/1979 OPEC raises prices 1979
Latin American Debt Crisis 8/1982 Plaza Agreement 9/1985 Louvre Accord 2/1987 Maastricht Treaty 9/1991
EMS crisis 2/1992 Peso Collapse 12/1994 Asian Crisis 6/1997 Russian Crisis 8/1998
Euro Launched 1/1999 Brazilian real crisis 1/1999 Turkey 2001 Argentine peso crisis 1/2002
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Why do Currency Crises Happen?

• Long run In theory, a currencys value mirrors
  the fundamental strength of its underlying
  economy, relative to other economies.
• Short run currency traders expectations play a
  much more important role.

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How do Currency Crises Happen?

• Mass exodus causes sharp drop in currency
  valuation ? currency crisis.
• Fears of depreciation become self-fulfilling
  prophecies.
• Policy for recovery unclear appears to be
  contextual. Therefore we can examine Mexican
  Asian crises to gain perspective.

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Mexican Peso Crisis (1994-95)

• The Mexican government announced a plan to
  devalue the peso against the dollar by 14.
• Investors response dump Mexican currency,
  stocks and bonds ? 40 drop in peso.
• Led to flotation of peso. Crisis spilled over to
  Latin America/Asia. Tequila Crisis.

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Importance of Mexican Crisis

• This was the 1st serious intl financial crisis
  sparked by cross-border flight of portfolio
  capital.
• In prior crises, currency had been abandoned
  here also the stocks bonds.
• Underscored degree of interdependency of
  financial systems world-wide.
• Highlighted the inherent riskiness of relying on
  foreign capital to finance domestic investments.
  
• Influx of foreign capital can cause overvaluation
  of currency.

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Asian Crisis (1997-98)

• Thai baht devalued on July 2, 1997. Sparked
  crisis region-wide overflowed to Russia and
  Latin America.
• Far more serious than the Mexican peso crisis in
  terms of the extent of the contagion and the
  severity of the resultant economic and social
  costs.
• Many firms with foreign currency bonds were
  forced into bankruptcy.
• The region experienced a deep, widespread
  recession, which is still ongoing, despite IMF
  bail-out packages.
• Moral hazard?

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Why Asia?

• Weak domestic financial systems.
• Free international capital flows.
• Market sentiment sparked contagion.
• Inconsistent economic policies and incomplete
  disclosure thereof.
• Hardest hit countries (Indonesia, Korea,
  Thailand) had especially high ratios of
• (1) short-term foreign debt/FX reserves and
• (2) broad money (representing banking system
  liabilities)/FX reserves.

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Lessons?

• Financial market liberalization must be paired
  with development of strong domestic financial
  system.
• Note Mexico and Korea joined the OECD a few
  years prior to crises OECD membership had
  required significant market liberalization.
• Governments should
• strengthen financial market regulation
  supervision
• discourage short-term cross-border investments
• encourage FDI and long-term equity bond
  investments.

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IMF on Currency Regimes

• IMF Regime Classification
• No separate legal tender (39) Ecuador
• Currency Board (8) commit exchanging domestic
  currency at a fixed rate to foreign currency.
• Conventional Fixed Peg (44) Country pegs its
  currency (formally) at a fixed rate to major
  currency 1 variation
• Pegged Exchange w/in Horizontal Bands (6)
  maintain within margins wider than 1 around de
  facto fixed peg.
• Crawling Peg (4) Currency adjusted periodically
  in small amounts at pre-announced rate

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Contemporary Currency Regimes

• Exchange Rates w/in Crawling Peg (5) Currency
  maintained within certain fluctuation margins
  around a central rate that is adjusted
  periodically
• Managed Floating w/ No Preannounced Path for
  Exchange Rate (33) Monetary authority active
  intervention in foreign exchange markets
• Independent Floating (47) Exchange rate is
  market determined.

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Fixed vs. Flexible Exchange Rates

• Why countries prefer fixed exchange rates?
• Stability in international prices for the conduct
  of trade
• Anti-inflationary, requires country to follow
  restrictive monetary fiscal policies
• Credibility, if central banks maintain large
  international reserves to defend fixed rate
• Fixed rates may be maintained _at_ rates
  inconsistent with economic fundamentals. For
  example, Asia these days

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The curious case of Asia

• Recently Asian countries have shown reluctance to
  allow their currencies to rise against the dollar
• Why?
• Prefer fixed exchange rates (ergo stability)
• Consequences
• Rise of the euro good or bad? What do you
  think?
• Solutions
• Float of exchange rates of Asian economies.
• Financial sector liberalization in China.

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Ideal Currency Or Impossible Trinity?

• Exchange rate stability value of currency would
  be fixed to other currencies
• Full financial integration complete freedom of
  monetary flows allowed, traders investors could
  move funds in response to economic opportunities
• Monetary independence domestic monetary
  policies by each individual country to pursue
  national economic policies, e.g. limiting
  inflation, foster prosperity full employment.

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The Impossible Trinity
Can have only 2-sides/ system.E.g., if Monetary
Independence Financial Integration, cannot
attain Exchange Rate Stability.
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Emerging Markets Regime Choices

• Currency Boards countrys central bank commits
  to back monetary base, with foreign reserves _at_
  all times
• means a unit of domestic currency cannot be
  introduced w/o an additional forex reserves
• Argentina (1991), fixed Peso to US
• Bulgaria (1997), fixed Leva to Euro.

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Emerging Markets Regime Choices

• Dollarization use of US as official currency
• Panama, 1907 Ecuador, 2000.
• Why dollarization?
• Removes possibility of currency volatility
• Eliminate possibility of currency crises
• Economic integration with US other dollar based
  markets
• Why not dollarization?
• Loss of sovereignty over monetary policy
• Loss of power of seignorage, the ability to
  profit from printing own money.
• Central bank no longer lender of last resort.

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Living on the edge

• Currency Board or Dollarization
• No monetary independence
• No political influence on monetary policy
• Seignorage rights lost

• Free-Floating Regime
• Currency free to float
• Independent monetary policy free movement of
  capital allowed, but _at_ loss of stability
• Increased volatility

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The Euro

• European Monetary System (EMS)15 Member nations
• Maastricht Treaty 92 timeline of economic
  monetary union.
• Convergence criteria called
• Nominal inflation lt 1.5 above average for EU
  lowest 3 inflation rates year before.
• LT interest rate lt 2 above average for EU lowest
  3 interest rates.
• Fiscal deficit lt 3 of GDP.
• Government debt lt 60 of GDP.
• European Central Bank (ECB) established.

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The Euro Monetary Unification

• The euro, , was launched on Jan. 4, 1999 with 11
  member states
• Benefits of the euro?
• Lower transaction costs in EU.
• Currency risks reduced.
• All consumers and businesses, both inside and
  outside of the euro zone enjoy price transparency
  and increased price-based competition

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The Euro Monetary Unification

• Successful unification ?
• ECB has to coordinate monetary policy
• Focus on price stability.
• Fixing the euro
• 12/1998, national exchange rates were fixed to
  the Euro.
• 1/1999 euro trading on world currency markets.

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Euros Way-up
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Tradeoffs b/n Exchange Rate Regimes
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What Lies Ahead?

• Tradeoff b/n rules discretion, cooperation
  independence.

• Bretton Woods

• Gold Standard

• European Monetary System

?

• US Dollar, 1981-1985

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Summary

• Terminology
• Foreign currency exchange rate
• Spot exchange rate
• Devaluation (revaluation)
• Depreciation (appreciation)
• The impossible trinity of goals for forex fixed
  value, convertibility, independent monetary
  policy.
• Currency board or dollarization?
• Fixed vs. Floating Exchange Rates.
• Euro advent.